Why Try a Worker Co-op

Business owners should think carefully and develop a strategic plan for exiting a business. You, the business owner looking to sell, can leave your business by selling it to family members or third parties, merging it into a larger organization, selling it to employees through an employee stock ownership plan (ESOP), or by simply closing up shop. However, one often overlooked method that business owners, especially small to medium-sized business owners, might consider is having the employees form a worker cooperative. You can then sell the business to the cooperative with some possible tax advantages.

The benefits from this type of exit strategy are numerous. For the employees, a purchase of the business would mean job stability, more control over their careers, higher morale, and usually better productivity. unlike an ESOP, where the employees are simply beneficiaries of a trust holding their stock, with little management authority, in a worker cooperative the employees can directly operate the business. Through year-end distributions of net margins, the employee-owners build up equity accounts that act as their retirement nest egg.

Also, unlike an ESOP, there are no added administrative costs in forming or maintaining a worker cooperative and the regulatory environment

is much less strict. A cooperative is a business model, not an ERISA regulated retirement plan, and therefore it is governed by state incorporation statutes and federal tax statutes.

Selling to a worker cooperative is a business exit strategy that ensures your business will continue, while also providing the seller with compensation for creating and growing the business. If the sale to employees is completed over a number of years, you could continue with management and training until the sale is finished. Note that not all the employees of a company have to become member/owners of the worker coop. But for those who choose to become owners, they can be trained in the responsibilities of ownership and management, giving you assurance that the company will continue as planned. The sale of the company to the employees can take place on a designated date or over a substantial period of time (such as five to ten years). This would allow the employees or the co-op to pay the entire purchase price over several years, often out of net profits. Rhere is the possible favorable tax treatment for you, the selling owner under internal revenue code §1042 (26 u.s.c. § 1042).

Section 1042 Tax Treatment

Code §1042 allows you to sell your stock to a worker cooperative with resulting favorable tax treatment. To qualify for the favorable treatment under §1042, the proceeds from the sale of your interest in the company must be reinvested in a “qualified security,” and the gain then is deferred indefinitely.  In other words, the capital gains that result from the difference between what you invested in the company and what you receive upon sale will not be taxed unless or until you sell the “qualified security” that you purchased from the proceeds of the sale.  And then the gain will be recognized as a long-term capital gain only to the extent that the amount realized on the sale exceeds the cost to the owner of the qualified replacement property (26 U.S.C. 1042(a)(3)).

For a very simple example, say you invested $100,000 in your company and over the years it has gained in value.  You sell the company to a worker cooperative for $1,000,000. You use those funds to purchase a qualified security (like Apple or Amazon stock). When those shares are sold in the future, the tax will only be on the difference in value relative to when you purchased the Apple stock and when you sold it.  If you don’t sell it and the Apple stock becomes part of your inheritance, there will be no capital gains tax liability to you or your heirs. If you have not used the §1042 advantages, then you will be required to pay capital gains tax on the $900,000

Specific requirements must be met before §1042 is available to you. To qualify for § 1042 treatment, there is a four-step process:

1. The sale of the company’s stock must be to an eligible worker-owned cooperative or to an ESOP.
2. The worker cooperative must own at least 30% of the total value of all outstanding stock, or of each class of outstanding stock, immediately after the sale.
3. The taxpayer (either you or the cooperative) must file a written statement with the IRS consenting to the application of §§ 4978 and 4979A with respect to the owner or the cooperative.
4. Your holding period with respect to the purchased qualified securities must be at least three 3 years (determined as of the time of the sale).

The first step is satisfied by the formation of a cooperative under Title 7, either Article 56 or Article 58, of the Colorado statutes.

The second step requires some financial planning on your part and the employees who will be purchasing the business. You have to look seriously at your employees and have lengthy discussions with them about potential ownership.  Not all employees may be capable or willing to become owners.  You may have to bring in a new person who will eventually replace you as the senior manager if you do not have personnel you believe can be trained to do what you do.  Then you must determine the value of the company, which may require the services of a business valuation professional. The employees will be required to find a way to purchase at least 30% of the business the first year of the sale. This may require the employees to obtain a loan or other funding sources for the initial payment. There are other financing options available, such as an owner carry-back, or the cooperative itself executes a loan for the 30% initial payment. The remaining 70% of the purchase price can be paid over a number of years, as determined up front by you and the new employee-owners.

The money you receive for the sale of the business must be invested in qualified replacement property for a minimum of three years. “Qualified replacement property” is defined in the Code, but the definition is a little cumbersome. Generally, it means any security issued by an active domestic corporation that is not issued by the company being sold and that does not have passive investment income in excess of 25% of the gross receipts of the corporation for the preceding tax year.

Codes §§ 4978 and 4979(a) concern tax on certain dispositions by cooperatives and generally provide that there will be a tax imposed if the cooperative sells the securities it purchased from the owner before the three-year holding period provided in step 4 above is concluded. Of course, a tax professional should be consulted concerning whether a §1042 election is appropriate or even warranted for your particular business.

Example

As a simplified example of how this might work, suppose that a company has ten employees and you wish to sell the company for an agreed-on value of $750,000. All of the employees wish to purchase the company from you (although it is possible to sell the company to fewer than all employees). The employees form a worker cooperative and purchase the entire company.

The employees purchase at least 30% ($225,000) in cash on the date of sale and the new cooperative signs promissory notes to you for the remaining 70%. You use the $225,000 to purchase qualified replacement property to be held for at least three years. You and the employees are now owners of the cooperative, each with one vote and each with the power to participate in the governance of the company. As part of the agreement between you and the new employee–owners, it could be provided that you retain certain management authority or a Board seat until more of the notes are paid.

Over a period of years (all as agreed), either the cooperative itself or the employees can pay for the remaining ownership interests. Payment can be made from net margins or by the employees making additional capital contributions, or by raising capital from non-member outside investors (e.g. through a private placement offering, a crowdfund offering, or a direct public offering).

Eventually, you are paid in full and can retire, knowing that your company will continue with owners that you have trained and who you believe will continue your legacy. The community has not lost a business and its tax base, the employees have job stability, and their families have the knowledge that a nest egg is growing in the company. When an employee leaves the company or retires, the cooperative can redeem his or her equity account over a period of time or all at once, as agreed by the employee–owners.

Conclusion

The worker cooperative is a flexible business model that can be used by any group that is interested in creating a democratic decision-making company that benefits the employee–owners with job security, a sense of pride, and possible retirement income. In today’s economy, many small business owners would like to retire or at least start planning their retirement. However, they may find that there are very few opportunities to sell their businesses to a third party, and family members may not want to continue the company. By using a worker cooperative model and selling your business to employees who have the knowledge and enthusiasm to continue to provide products or services, you can feel good about passing the business along to someone who cares.